Growing in popularity?

David Adams explores the differing levels of implementing ETFs by pension schemes across Europe

Assets invested in Exchange Traded Funds (ETFs) worldwide reached an all-time high of $1.7 trillion at the end of August, according to figures from research and consultancy firm ETFGI. ETF fans praise the liquidity they offer – as tradable as equities – along with relative transparency in terms of costs, risk and return. They have evolved into a multitude of forms, covering a vast range of asset classes and suitable for a wide variety of investment purposes: there were 1,327 ETFs in Europe in August 2012, offered by 40 providers on 22 exchanges and holding $295 billion in assets, according to ETFGI.

But concerns over the risks asso-ciated with ETFS, with the synthetic, derivative-based ETF in particular, have led to some pension funds and their advisers viewing them with a degree of caution, or suspicion.

In August, 507 of the European ETFs used physical replication, while 813 were synthetic. But the physical ETFs held more assets: $186 billion to $109 billion. While ETFs are becoming more popular in general there were actually net outflows away from synthetic ETFs in Europe during 2011.

This may explain in part why use of ETFs by pension funds seems to vary considerably from country to country, with French, German and Swiss pension funds more willing to use them than counterparts in the UK or the Netherlands, for example.

But the picture is complicated. It is probably true to say that larger pension funds, wherever they are, are less likely to use ETFs strategically, because they have the resources to implement more sophisticated asset allocation strategies instead. But in July the Financial Times reported a rise in the number of larger UK pension funds using ETFs as overlays to existing holdings in emerging markets and high yield bonds – a month after the paper had quoted an expert saying that UK pension schemes “rarely, if ever” invest directly in ETFs.

The word ‘directly’ may be important here: pension funds may be exposed to ETFs indirectly, without trustees’ knowledge, because fund managers often use them, during transition processes, for example.

“It’s very difficult to get meaningful statistics on who’s using ETFs,” says S&P Dow Jones Indices vice-presi-dent John Davies. “In Europe only about a third of all ETF trading and investing is reported on exchange.”

It is certainly true that the liquidity ETFs can offer has looked more attractive to pension funds since the 2008/2009 crisis, suggests Mercer Investments, Netherlands principal Dennis van Ek. Pension funds often now act in a more tactical way than was once the case, particularly if a global tactical asset allocation (GTAA) is being undertaken. “You have to be thinking in the long term, but if bonds and currencies change overnight because of events then you do need to take notice,” he says.

That liquidity also makes ETFs useful as a tool for transition management. “They can be used during a transition from one manager to another, or when [a manager is] moving asset allocation, because the ETF is a very simple, transparent vehicle,” says Davies. “For larger schemes they can act as a tool to manage the flow of cash between allocations; and for cash equitisation while they’re waiting to invest properly in a given market.”

Pension funds also appreciate the relative transparency offered by an ETF, says SCM Private chief investment officer and founding partner Alan Miller. “You can see pretty much every single holding,” he says. “With something like a hedge fund you rarely see the whole portfolio on a daily basis – you probably see it once or twice a year.” That transparency and liquidity also makes ETFs an attractive tactical tool for fund managers pursuing diversified growth strategies.

But some doubts remain. With a synthetic ETF much depends on the issuing investment bank. “Post 2008 institutional investors are acutely aware of counterparty risk,” says BNY Mellon Asset Servicing head of global exchange traded fund services Joe Keenan. “If you buy an ETF synthetic wrapper you’re going to want to be confident that the fund will have underlying collateral that will be liquid and that will protect if not all at least the majority of your investment. Risk averse clients are often more comfortable with physically replicated products.”

Pension funds may also be influenced by their advisers’ views, particularly if trustees do not them-selves possess a huge degree of financial expertise. Miller believes some consultants have failed to give ETFs the due consideration they deserve. “On the pensions side, consultants haven’t looked at them properly, if at all,” he complains.

But despite this – and bearing in mind the difficulty of getting a completely clear picture as to where in Europe pension funds are using ETFs – the general trend does seem to be that they are gradually becoming more popular and used for an ever-widening number of purposes, across Europe.

“In general the pension funds in Holland and Scandinavia tend to run more money in-house and make decisions on their own,” says ETFGI partner Deborah Fuhr. “So they have been significant users of ETFs for equitising cash, for emerging market exposures. They have found ETFs can be quite cost efficient, especially if they lend the ETF shares they own.”

In the Netherlands, says van Ek, ETFs are most often used within passive investment strategies, although the cost for institutional investors can be prohibitively high in comparison with the cost of outsourcing passive management. There can be other drawbacks, he adds: it can be harder to take a position in precious metals or to ensure a socially responsible investment policy is being adhered to when using ETFs.

“In Germany the adoption of ETFs by large pension funds has grown continuously over recent years,” claims ETF provider iShares in Germany, Austria and eastern Europe head of sales Michael Gruener. “ETFs are used as a core building block for strategic asset allocation, especially for more specialised fixed income – such as investment grade credit and high yield – and core equity exposures such as SP500.

“German pension funds have also become more tactical in terms of exposures,” he continues. “ETFs are an ideal tool to benefit from shorter term market developments. Lastly, ETFs are used as a tool for transition management while new investment strategies are screened and implemented.”

“The biggest change I have observed in pension schemes over the last two to three years is a renewed focus on governance, as a result of the 2008/2009 crisis,” iShares head of UK sales Mark Johnson says.

“Because of that volatility pension funds determined that they needed to bring in experts to work with trustees. For those pension schemes that are larger, more sophisticated and have an internal team, there is growth in the use of dynamic trading strategies. That’s where we see a role for ETFs. Usage today is coming from a fairly low base, but we’re having a number of very interesting conversations as to the role they could play. For small and medium-sized schemes ETFs are also being used in outsourced diversified growth solutions.” Johnson reports some pension schemes asking managers to combine an unconstrained invest-ment strategy with a beta approach, possibly involving the use of ETFs.

“Not only do [pension funds] face the challenge of finding asset classes to invest in to try and find some alpha, they’ve also got to look at the costs,” notes Davies. “On the whole ETFs are a much more cost-effective way of accessing some markets that traditionally were expensive to invest in.”

He points out that the ETF market is still very small in comparison to the mutual fund market – but also that more providers which previously focused on mutual funds are adding ETFs to their product suites.

“There will be more products coming to market, but there will also be consolidation,” Davies continues. “There are 170-odd ETF providers globally and I don’t think all of those will last the course against companies like State Street and BlackRock. So it’s a competitive market, but one that I think will continue to grow; and pension funds will use them more and more.”

Written by David Adams, a freelance journalist

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